How to make your portfolio inflation-proof

How to make your portfolio inflation-proof

This July, Reserve Bank of India Governor D Subbarao spoke of his receding hairline and the high price he had to pay for a haircut. The idea was to drive home the impact of rising rates of inflation.

He said he used to pay Rs 25 for a haircut 20 years earlier; that went up to Rs 50 even as his hair thinned. "Now, when I have virtually no hair left, I pay Rs 150 for a haircut," he said.

Since the beginning of this financial year, the wholesale price index (WPI) inflation has averaged 7.6 per cent and the consumer price index (CPI) at 10.12 per cent. As a result, the real returns from your investments have been falling sharply.

Business Standard asks four experts to give their views on how to beat this menace. Most feel gold - an important instrument to beat inflation - should form at least 10-20 per cent of your portfolio.

Also, though equities have not done so well in last three years, our experts advise it aggressively. Fixed maturity plans also find favour with them, as these products are offering slightly higher returns than fixed deposits:

How to make your portfolio inflation-proof

In Friedman's words, inflation is a form of taxation that can be imposed without legislation.

It erodes the purchasing power of idle wealth; most noticeable in the current times, when inflation is hovering around 8 per cent - higher than the interest earned from your bank's savings account. This means, the value of Rs 100 in your wallet, if left undeployed, shall be Rs 92 in a year.

So, it is important you invest your cash surplus to beat inflation and at least retain your money's purchasing power. For this, choose a portfolio with instruments like equity, debt and gold and make appropriate asset allocation on the basis of your risk profile.

In a conservative portfolio aimed at beating inflation, you can allocate 15-25 per cent in equities, 65-75 per cent in debt and 10-15 per cent in gold.

For investments in equities through mutual funds, systematic investment plan (SIP) should be used.

Nilesh Shah

Asset class

Allocation

Equity (Direct and/orMutual Funds)

15 – 25%

Debt (Short-term orFMPs / Long-term)

65 – 75%

Gold (Mutual Funds)

10 – 15%

You can adopt a smarter route by investing an amount across multiple funds based on parameters like price-to-earnings (P/E) ratio that reflect valuations - investing more when P/E is low, and less when P/E is high. This is better than a regular SIP, where investments rely on time of entry than valuations.

Large-cap funds that comprise stocks of companies with better visibility of earnings growth, robust management and time-tested performance are recommended. You can also invest directly in stocks with adequate and thorough research.

In debt, you can invest in short-term mutual funds, including fixed maturity plans (FMPs) that accrue interest and provide fixed income.

Also, if your risk profile allows for an allocation to long-term funds, you can benefit from capital appreciation along with accrued income in a falling interest-rate regime.

Historically, gold has been viewed and held as an ideal inflation-management instrument. Allocation to gold can be made physically or preferably through gold funds which are operationally more efficient, offering an easier mode of investment.

Remember to inflation-proof your portfolio through diversification and appropriate asset-allocation.

How to make your portfolio inflation-proof

Whether your money is invested or is sitting pretty under your mattress, it loses value over time. If inflation is 7 per cent and you allow your money to lie idle in a savings bank account, where you get interest at 4 per cent, you have lost 3 per cent in a year.

How the money should be allocated to asset classes is a function of time horizon, kinds of returns you expect and the amount of risk you want to take.

I'd recommend 10 per cent exposure to tax-free bonds, where you can hope to earn 7.5 per cent a year. A good FMP can take 15 per cent of your resources. You can expect to make 8 per cent from that.

You can invest in a gold ETF too. It will be a hedge against risks to your equity investments. If equities don't do well, it can make up for some of the returns.

But, the bulk of your returns will have to be generated by equities alone. There are no long-term capital gains in equities and dividend is tax-free, but share prices are known to take a knock in bad times.

How to make your portfolio inflation-proof

Indians are generally conservative investors, preferring to park their money in bank fixed deposits (or even savings bank accounts). This is primarily driven by our need for safety of capital, familiarity with the product, and access to liquidity in times of requirement.

Unfortunately, we don't realise we are actually losing our capital due to the loss of purchasing power ability.

The aim to preserve capital is defeated by inflation. Simply put, assume you invest in an 8 per cent FD, which will give you 5.6 per cent after tax (at 30 per cent rate).

You have a monthly household expenditure of Rs 20,000 (Rs 240,000 annually). After five years, at an average seven per cent rate of inflation, your monthly expenditure for the same articles would be Rs 28,000. This would mean an annual expense budget of 336,000.

If you had invested Rs 42 lakh (Rs 4.2 million) for a return of Rs 240,000, you will be short by Rs 96,000 five years later, simply because tax-adjusted returns from FDs could not beat inflation.

Inflation is, thus, an invisible trap that investors generally fall prey to, without realising how it slowly erodes the real value of their wealth.

For the long term, some allocation needs to be given to tax-free coupon-bearing bonds like NHAI, PFC, IRFC or Hudco to capture tax-efficient cash flows for the very long term, where the cash flow yield is higher than inflation.

However, since the coupon-bearing instruments suffer from reinvestment risk, some allocation needs to be in zero-coupon bonds like Nabard to minimise reinvestment risks while capturing the prevailing interest rates for the long term in a tax-efficient way.

Ashish Kehair

Investment Strategy

Instrument

% Allocation

Expected pre-tax returns

Expected post-tax returns

Cash - less than 3 months

Ultra Short Term Funds

5

8.5

8

Active Investments - 6 to 18 months

Short Term Income Funds

10

9.5

8.4

Short to medium term held to maturity - 1 to 5 years

Fixed Maturity Plans

10

9.2

9

Long term held to maturity - coupon bearing

NHAI/HUDCO/PFC/IRFC tax free bonds

15

8

8

Long term held to maturity - without reinvestment risk

NABARD/REC zero coupon

10

8.8

8

Long term growth strategy - equity

Equity MF / Direct Equity

25

15

15

Long term alternate strategy - gold

Gold ETF

5

10

9

Long term alternate strategy - Real estate

Real estate / real estate linked funds

20

12

11

Total portfolio returns

100

11

10.5

All returns are indicative; post-tax returns are calculated on the bais of prevailing tax laws at a marginal tax rate of 30.9% & DDT of 13.5% Shah believes the allocation of investments in the suggested proportion could help beat the effects of inflation

How to make your portfolio inflation-proof

Equities as an asset class have managed to barely deliver a compounded return of under 3 per cent (measured by broad indices) over the past five years. During this period, precious metals (silver and gold) have delivered between 13 and 19 per cent.

However, the return differential between these asset classes during long periods also tends to be large and volatile.

So, a portfolio approach that creates a judicious balance of different asset classes optimised to one's risk appetite is essential, so that aggregate returns in excess of inflation can be generated.

To sustain returns ahead of inflation over long periods, equities as an investment avenue should merit a higher allocation, tempered down only by the risk-taking ability of an investor.

This is notwithstanding the recent weak performance of equities, because they are known to have bouts of sub-par returns, but not for very long. Active investment strategies can be used to deal with sub-par market returns during shorter durations and the higher level of perceived risk in equity investments.

Besides, equities are the only asset class that allows wealth-creation possibilities over an individual's life span, to permanently overpower inflationary pressures.

A portfolio comprising a third of allocations to equities, going up to as high as 50 per cent, depending on an investor's age and risk profile, would be recommended. Commodities and debt could equally constitute the balance.